Looking back at Kronos Worldwide

Important:
this text demonstrates how we analyse individual companies. This document was
compiled by the fund managers of the Kempen (Lux) Global Small-cap Fund (‘the
fund’), managed by Kempen Capital Management N.V. (‘Kempen’). Please also see
the declaration and disclaimer at the end of this text.

Date: January 2018

The efficient market hypothesis states that a share price reflects the intrinsic value of that share at all times, because all publicly-available information and future expectations have been correctly incorporated into it. In practice, we constantly see that markets are far from efficient. This certainly applies to small caps, smaller listed companies, which few investors take the trouble to examine. This generates opportunities for active small-cap managers such as Kempen.

We would like to illustrate this using an example: Kronos Worldwide. We wrote about Kronos in January 2016; at the time, its share price was 4.56 US dollars (closing price on 15 January 2016) and we had just included it in the Kempen (Lux) Global Small-cap Fund. Now, just under two years on, the price stands at 25.77 US dollars (closing price on 12 December 2017), yet the company has not changed materially. We have since sold our position as we can no longer find any justification for its current valuation.

Source: Factset (shareprice Kronos Worldwide in USD from 1/1/2014 to 12/12/2017) and Kempen (date initial purchase and final sale)

Allow us to take you back in time and describe the events of the past two years.

WHY WE WERE ENTHUSIASTIC ABOUT KRONOS

In September 2015, the share price of Kronos Worldwide caught our attention as it had declined over 50% since the start of that year. At that time, the annual dividend per share of 0.60 US dollars translated into an attractive dividend yield. After extensive analysis, we decided that there was substantial hidden value in Kronos. As long-term value investors we concluded that Kronos was an interesting investment for our fund. In the Quarterly of January 2016, we described in six steps why we were enthusiastic about Kronos:

Step 1: Kronos in a nutshell.

Kronos is a producer of titanium dioxide, a white pigment used to whiten all kinds of products. Over 50% of the world’s titanium dioxide goes into paint and coatings, but it is also used for plastics, paper, toothpaste, sunscreen and cosmetics. There is currently no really effective substitute for titanium dioxide; no other white pigment has the physical properties for achieving comparable brightness and opacity at a similar cost price.

Step 2: Industry recovering from oversupply.

There are only a few producers of titanium dioxide worldwide. Other major players are Chemours, Huntsman, Tronox and Cristal. After peaking in 2011, the price of titanium dioxide had been declining, mostly due to overcapacity caused by new Chinese players entering the market. In January 2016, we wrote that we believed that the equilibrium between supply and demand would improve as many smaller Chinese producers were scaling back capacity and some Western players had closed plants. In December 2015, several producers announced selling price increases effective as of January 2016. We viewed this as a positive sign of a recovering market.

Step 3: Strong financial position.

As long-term investors, we examined Kronos’ ability to survive periods of weaker earnings or even periods in which it made a loss. We therefore spent time not just assessing its balance sheet and cash flow statements but also comparing its financial position to its competitors. In our opinion, Kronos had one of the most solid balance sheets in the sector.

Step 4: Significant hidden value.

A closer look at the balance sheet allowed us to identify what we saw as significant hidden value. Kronos was founded in 1916 and most of its production facilities were bought many decades ago. These are included on the balance sheet at historical cost price, minus depreciation. Furthermore, these production facilities are in strategically valuable locations, such as Louisiana (US), Bremerhaven (Germany) and Frederikstad (Norway). Kronos also has its own titanium dioxide mine in Norway. According to the company’s own figures, this mine contains sufficient reserves to supply its European business with raw materials for fifty years. We concluded in January 2016 that all these assets were in the books at levels well below the market value. Lastly, Kronos had losses from the past that could be used to offset taxes going forward. These were also not visible on the balance sheet at that time, although they are valuable for shareholders. All in all, we estimated the real value of Kronos to be substantially higher than its January 2016 share price.

Step 5: Operating profit.

Besides looking at the value of its net assets, we valued Kronos based on its ability to generate earnings. Given the cyclicality of the business, we decided to look at the earnings Kronos could make in an average year. Based on its production capacity and average historical profit margins, we identified interesting upside potential compared to the share price at the time.

Step 6: Its own management also bought Kronos shares.

We proved not to be the only ones who recognised the potentially high value and potentially higher Kronos share price. The senior management of Kronos, some of whom had been with the company since the 1980s, had themselves acquired more shares in the second half of 2015. The Chairman had even increased his investment by over two million US dollars since August 2015; and in doing so doubled his position in the company’s stock.

PATIENCE WAS REWARDED MORE QUICKLY THAN EXPECTED

As we wrote in January 2016, in this type of investment case there is always the question of whether – and if so, when – the hidden value will ever manifest itself. We pointed out that replacement value becomes more relevant as the market picks up. As long-term investors, we can allow ourselves to be patient; the investment horizon for our investments averages four to five years. In the case of Kronos, however, we were proved right within a shorter timeframe. In 2016, Kronos’ share price increased by over 100 percent; this made Kronos the largest gainer in the Kempen (Lux) Global Small-cap portfolio in that year. The price more than doubled again in 2017 (up to and including 12 December 2017).

Selling price hikes

The main reason for the successful course of the Kronos share price over the past two years would seem to be a sharp upturn in the selling price, driven by sound end demand. The handful of players makes the sector concentrated and creates a high degree of transparency with respect to the selling price. Chemours was the first to announce an increase in its selling price in December 2015. A number of producers were facing severe difficulties as the selling price was below cost price at that point. It was only a matter of hours and days before all the Western players followed suit on the price increase.

The equity market was sceptical as to whether this increase could in fact be implemented, but the pigment producers succeeded in doing so. They were aided by strong end demand, as economic growth was persisting in both North America and Europe and titanium dioxide is used in a wide range of products. Moreover, stocks had been reduced to a minimum within the value chain, squeezing the supply as demand rose.

At the same time, the supply of pigment from China came under pressure. Smaller and less efficient producers were unable to survive under conditions of low selling prices and were forced to close. Furthermore, China is the world’s largest manufacturer of steel. The raw materials for titanium dioxide are a by-product of steel production. Pressure from the Chinese government to curb national steel production, with a view to tackling both overcapacity and environmental pollution, unintentionally led to fewer raw materials for the production of titanium dioxide. This resulted in a higher cost price for pigment producers in China, which in turn were forced to raise their selling price. Western producers profited from this.

Further consolidation in the sector

In February 2017, Tronox announced its intention to acquire competitor Cristal. In principle, further consolidation should be good for profit margins in the industry. Firstly, it means fewer players and therefore in all likelihood more rational behaviour. Secondly, the combination of Tronox and Cristal is fully vertically integrated, i.e. they both possess enough of their own raw materials for the production of titanium dioxide and consequently do not need to turn to the external market for feedstock. This means fewer buyers and therefore improved buying conditions for players such as Kronos. As of the time of writing this Quarterly, however, the acquisition had not yet been approved by the US regulatory authorities.

Gradual reduction of the position

The Kempen (Lux) Global Small-cap Fund no longer holds a position in Kronos. The last batch of shares was sold on 18 September at a price of 22 US dollars. As portfolio managers, we constantly aim to be able to justify our investments based on share prices and what we believe the underlying shares to be worth. If we see no further upward potential, we divest ourselves of the holding. We reduced our position in Kronos gradually as the share price increased. Yet Kronos remains on our radar. We know the company well and do not exclude the possibility of investing in the company again in the future, when market sentiment reverses.

Although a reversal in sentiment yields opportunities, this case demonstrates the difficulty of investing in the commodity sector: operating profits can be highly volatile due to fluctuations in selling prices that have a direct impact on earnings. This impact is subsequently projected onto share prices.

What are the main criteria in such cases? There needs to be a structural demand for the product, with restricted available alternatives. Moreover, companies in the sector need to have relatively low cost prices and sound balance sheets in order for them to withstand difficult periods for longer and better than their peers.

This document is prepared by the fund managers of Kempen (Lux) Global Small-cap Fund (‘the Fund’),managed by Kempen Capital Management N.V. ("Kempen‘’). The views expressed in this document may be subject to change at any given time, without prior notice. Kempen has no obligation to update the contents of this document. As asset manager Kempen may have investments, generally for the benefit of third parties, in financial instruments mentioned in this document and it may at any time decide to executebuy or sell transactions in these financial instruments. The information in this document is solely for your information. This document should not be considered to constitute an investment recommendation and it is not intended as an offer or a solicitation to buy or sell any financial instrument mentioned in this document. This document is based on information that we consider reliable, but we do not represent that it is accurate or complete, and it should not be relied on as such. The views expressed herein are our current views as of the date appearing on this document. This document has been produced independently of the company and the views contained herein are entirely those of Kempen.